India's crisis buffers are part optical illusion

A bear market magnifies weaknesses. In India, imported inflation caused by the war in Ukraine and aggravated by the US Federal Reserve's aggressive rate hikes are depressing the currency and reviving the country's terrible twin deficits – the current account and the budget. The government's defence buffers, key to maintaining foreign investors' confidence and propping up the exchange rate, are thinner than they look.

Rocketing costs of imported food and energy will nearly triple the current account shortfall to 3.2% of GDP by March, Emkay Global estimates. Meanwhile, the fiscal shortfall remains high at over 6% of output, limiting room for further spending. The rupee has softened 6% to trade around 79 per dollar in 2022, a new record.

Fiscal and monetary policy have necessarily diverged. The government has extended a free food scheme until September and slashed taxes on fuel to ease living costs, but the finance ministry's expenditure department warns against further generosity. To restrain consumer price inflation that touched 7% in June, Reserve Bank of India Governor Shaktikanta Das hiked benchmark interest rates. Foreign funds that own two fifths of India's equity market are nonetheless fleeing, accelerating the weakening of the currency. Keeping up with the Fed also risks stifling India's post-pandemic recovery. Gross bank credit grew 12.1% in May, which is good news but coming off a low base.

In this context, the rupee has unsurprisingly continued to weaken. New Delhi is suddenly scrambling to slow outflows, hiking taxes on gold imports read more and on petroleum exports, and Das has run down foreign exchange reserves to stem the rout: the stock has fallen to $593 billion in June, a decrease of nearly $50 billion since September. That remainder might sound intimidating, but it is only equivalent to 11 months of import cover, close to the pre-Covid five-year average, per Citi.

India's currency problem is not unique, and the economy is in better condition compared to other developing countries, in part thanks to its push to clean up bad debt before the Ukraine crisis hit. Policymakers had managed to kill off an earlier so-called twin balance sheet problem, of which the fiscal deficit was one half, by slashing bad corporate debt to a six-year low as of March. But if unilateral intervention to defend the rupee doesn't work, India will have wasted precious reserves and damaged the central bank's credibility.

India raised taxes on gold imports, petroleum product exports and crude oil production as of 1 July. Import taxes on gold were lifted to 12.5% from 7.5%. The country is the world's second biggest consumer of the yellow metal and meets most of its demand from overseas purchases. The measures are intended to support the exchange rate and slow energy price inflation.

The rupee is trading around 79 per dollar, weakening 6% since the start of the calendar year. That compares to a 5% softening in the Indonesian rupiah and 7% by the Thai baht.

Consumer prices including food and fuel will rise 6.7% in the full year to March, the Reserve Bank of India estimates. India targets 4% inflation with a tolerance band of plus or minus 2 percentage points.